The Crisis in Tech Finance

Finance pays for new technologies, but financiers and technologists are sometimes at odds.

Financiers are by their nature conservative and analytical: they speculate on the future performance of markets, but the whole of their art is to make speculation as predictable as human affairs allow. By contrast, technologists are ambitious and optimistic: their innovations are applied science or engineering, but they believe their inventions will dominate markets or create entirely new businesses. Much of the business of technology finance consists of the wooing of wised-up financiers by ardent technologists.

But there is this paradox: while financiers are jaded, when they fall for something, they fall hard. They lose all their natural caution. I was the editor of the technology business magazine Red Herring during the Internet boom, and if it is now received wisdom that the venture capitalists and investment bankers who funded that mania were the cynical promoters of a financial euphoria, I never saw it. Financiers loved the boom more than most dot-com chief executives. But like disappointed lovers, financiers were bitter when their speculations proved unfounded, and without income or more capital, many of the companies that Red Herring wrote about were, in the end, ruined.

The long winter of technology finance followed. After Internet and communications company stocks collapsed in mid-2000, the market for initial public offerings of all technology companies closed, too – and without an “exit strategy,” venture capitalists couldn’t, or wouldn’t, invest in startups.

It’s been a long four and a half years. But 2004 seemed a kind of reflorescence for technology finance. Google’s wondrous IPO in August excited investors, but Google was the least of it. Two hundred thirty-three technology companies went public on U.S. exchanges in 2004, raising $43 billion, compared to 2003, when 79 companies went public, raising just $16 billion.

So why am I not happier? Because financiers are still bilious from the boom: they remain disinclined to invest in emerging technologies. As we describe in this month’s special report, “Tech and Finance 2005” (see story), total venture capital investments in the United States in 2004 were up 8 percent over 2003. That is all to the good. But worryingly, while the valuations for later-stage startups increased in 2004, money for younger startups did not. Venture capitalists are funding proven technologies at established startup companies, especially those whose work is relevant to Internet security, national security, and biodefense.

All of this would matter less if public companies were investing in emerging technologies. They are not. Over the last four years, corporations have spent less and less on basic research and development. Worse, the U.S. government is investing less in new technologies, too. In the 2005 federal budget, R&D spending has increased 4.8 percent to $132.2 billion, but 80 percent of that increase went to defense research – and most of that to new weapons systems like ballistic-missile defense. This meant cuts elsewhere: the National Science Foundation, for instance, saw its R&D budget decrease by .3 percent to $4.1 billion in 2005. Even the National Institutes of Health, long a favorite object of federal largesse, enjoyed an R&D budget increase of only 1.8 percent, to $27.5 billion – below the rate of inflation.

Distraught technologists might seem only to be saying, Can I have more money, please? – were it not for one thing. The drought of venture capital for early-stage startups, the indifference of public companies to basic R&D, and the emphasis on security by the government have conspired to create what our report calls an “innovation vacuum.”

The crisis can best be understood as an exaggerated example of what economists like to call the “transfer gap” – that is, the failure of emerging technologies that have been “pushed” (to use economic jargon) into research by technologists to be “pulled” into commercial development by financiers. The transfer gap occurs when financiers demand more certainty about the future prospects of a given technology than technologists can supply. When financiers feel very cautious, as they do right now, the gap gapes wide.

One solution proposed by Michael Kremer, the Gates Professor of Developing Societies at Harvard University, is for ­governments to bridge the transfer gap by making “purchase commitments” for the successful development of socially desirable technologies. The idea is pretty; it creates demand that startups can satisfy without asking governments to make choices better left to the markets. Certain of demand, financiers would be ready to back risky ventures. Kremer suggests using purchase commitments to create therapies for infectious diseases for the poor world. Defense spending is a kind of purchase commitment. Might it work for other technologies, too? Write to me at jason.pontin@technologyreview.com.